Less talk, more action

2014 EU-wide, Stress Testing: Scenarios, Methodologies and Challenges

By Luis Mariottoni, Risk Business Solutions Manager, SAS

Last week The European Banking Authority (EBA) published the details of its 2014 EU-wide stress test with its scenarios and methodology. This has triggered divergent opinions and criticism from market specialists and industry analysts. But there is one common theme: there is an urgent need for a structured, well-established and cost effective stress testing framework.

Some believe this new exercise is the most severe and comprehensive since EBA stress testing was adopted in Europe. Others think it may miss considerations regarding emerging issues in the region and may not seem so severe, compared to its equivalent on the other side of the pond.

The EBA created this stress test exercise in an attempt to fix the image of the EU financial sector before the - European Central Bank (ECB) assumes supervisory responsibility for the main European banks in November.

The EBA claims these stress test scenarios are extremely peremptory —and very prescriptive for national supervisors who will be carrying out the tests. It believes weak banks will fall short.

Some believe this new exercise is the most severe and comprehensive since EBA stress testing was adopted in Europe. Others think it may miss considerations regarding emerging issues in the region and may not seem so severe, compared to its equivalent on the other side of the pond.

“The methodology developed by the EBA for the stress test will ensure a robust and effective tool for supervisors to address remaining vulnerabilities in the EU banking sector,” said Andrea Enria, chairperson of the EBA.

From a macroeconomic point of view, this methodology is more severe than its previous versions. Over its three-year period – a year longer than the previous exercise – banks must show they can handle a drastic shift in the economy from expansion of 5.3 percent to contraction of 2.1 percent, much worse than the 0.4 percent decline in the last test. Such poor economic performance would drive unemployment up to 13 percent – almost 30 percent more than in the baseline scenario – and drag home prices down 20 percent on average, triggering defaults on loans held by banks on trading books, the EBA said.

Gonzalo Gasos, senior policy adviser for banking supervision at the European Banking Federation, is not wholly convinced these methods will work. “It is still too early to provide a detailed analysis, but our overall thinking to date is that the elements of the publication portray a scenario that is unrealistic and could put EU banks in a worse light than in reality,” he said.

“The static balance sheet assumption combined with caps on floors is overly conservative because the bank’s capacity to react to an adverse situation is not taken into account, unlike the tests run in the UK and US where dynamic balance sheets were admitted. We nevertheless welcome the fact that the EBA have respected the phasing-in of the capital requirements legislation,” he added.

Providing another perspective, David Keohane, blogger for the Financial Times, compares the EBA stress testing with that defined by the Federal Reserve in the US: “This would imply a cumulative real GDP decline of 2.1 percent over 3 years, notably less than the stress applied in the US CCAR (a 4.75 percent decline over 15 months) and a peak unemployment rate of 13.0 percent versus US CCAR 11.25 percent. Equity prices are expected to decline by 19 percent relative to the baseline (US CCAR -50 percent decline), residential house prices by 21 percent (US CCAR – 25 percent) and commercial property prices by 15 percent (US CCAR – 35 percent),” he concludes, “We think that means the EBA, when designing any stress test, has to hold fire for fear of spooking tender souls.”

There are also concerns about how current emerging situations would impact the financial sector in the upcoming future. A great example would be possible economic sanctions to Moscow and possible retaliatory reduction in Russian gas exports to Europe. A few analysts have criticized this aspect saying that this exercise focuses on history rather than future outlook.

From a methodology point of view, the EBA has made a change to the earlier presented version. It said that banks would now have to assume losses on some government bonds in their banking books, which goes in favor of the EBA and against past.

In this new version, the stress test covers different types of risks – credit, market, sovereign, cost of funds and interest income, non-interest income and expenses, and operational risk – with different levels of calculation complexity. Credit risk has the most complex methodology that takes into consideration detailed projections of probability of default and losses based on portfolio characteristics while market risk has a simpler calculation based on risk parameters.

There are a few challenges to be considered as part of the stress test framework:

Governance. Analyzing the different scenarios and their impact on calculations according to the method applied as well as the integration between risk and finance. "

Data readiness. Data may not be available for some of the banks at the granularity required, and data may not have the required quality. The Risk Assessment and Asset Quality Review steps of the Comprehensive Assessment are supposed to take care of these aspects. Banks need to be able to respond quickly to data validation and data correction needs.

Repeatable and efficient. This process needs to be built in a way that can be re-used and can consume fewer resources than it currently does once the supervisors have shown an appreciation to embed it as part of the bank’s strategy.

In summary, stress testing is here to stay and there will remain many questions to be debated, but certainly, this new methodology will continue to draw a great amount of attention from the stakeholders in the financial sector. The regulation will profoundly impact how the European and global economies evolve. It’s time to take action.

Read More

Read this point of view paper for advice on how banks can use comprehensive, enterprisewide stress testing for better risk and profitability management. It also overviews key elements of a successful approach to enterprisewide stress testing.

What's the difference?

Over its three-year period, banks must show they can handle a drastic shift in the economy from expansion of 5.3 percent to contraction of 2.1 percent – much worse than the 0.4 percent decline in the last test. Such poor economic performance would:

Drive unemployment up to 13 percent – almost 30 percent more than in the baseline scenario.

Drag home prices down 20 percent on average, triggering defaults on loans held by banks on trading books.